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Assessment of Efforts to Reform the European Union’s Emissions Trading System

In January, the European Commission published its proposal for the Climate and Energy Package 2030, which is slated for submission to the European Council this week. An important component of the proposed package is several changes to the European Union’s beleaguered Emissions Trading System (EU-ETS) For instructors who include a discussion of the EU-ETS, or more generally, emissions trading, in their courses, check out a new study by Paris-Dauphine University’s Climate Economics Chair. The study employed a model that sought to simulate supply and demand for emissions allowances (European Union Allowances or “EUAs”), year after year, incorporating the measures proposed by the Commission to date, including “backloading” allowances during the third phase of EU-ETS implementation and ratcheting up the linear annual emissions reduction factor from 1.74% to 2.2% from 2021 onward. It also focuses on the establishment of a market stability reserve (MSR) mechanisms, which, if implemented, will establish two triggering thresholds based on the quantity of allowances in circulation: a “high threshold” that triggers removal of 12% of the allowances in circulation when the quantity of allowances in circulation is greater than 833 Mt., and a “low threshold” that removes 100 Mt of allowances when the quantity of allowances in circulation is less than 400 Mt.

The study’s primary findings are as follows:

If EU-ETS market participants’ expectations lead to early reductions in emissions from 2021 onward and high banking of allowances (keeping allowances for future use) (designated in the study as a “high scenario”), then prices for EUAs may reach 50 euros per ton in 2021 and remain above price levels in the baseline scenario until 2030. By contrast, under a “low scenario,” in which participants don’t consider it necessary to immediately reduce emissions or hold many allowances for banking purposes, prices rise to lesser degree than under the high scenario and fall below the reference price when the MSR leads to additional allowances being injected into the market;

The MSR introduces greater price volatility into the market compared to a reference scenario without this mechanism. The reason is that the MSR lacks provisions to account for and respond to fluctuations in participants’ needs for allowances related to factors e.g. the evolution of abatement costs, relative energy prices, changes in technology and weather and economic conditions;

While banking in emissions trading systems is generally recognized as salutary, as it permits participants to reduce emissions in the most economically manner possible, the establishment of the MSR may scupper this result. The reason for this, argues the authors of the study, is that if agents decide to purchase allowances with the intention of banking them for future use, this could ease triggering of the MSR, “which … would go against their interests as an equivalent quantity would be withdraw from auctions.” Similarly, if agents decide they don’t need to purchase allowances currently, this would result in a lower number of allowances in the system, resulting in a release of additional allowances into the system from the MSR. This would also vitiate the economic efficiency of the system.

Among the in-class discussion questions that this study brings to mind are:

Given what you know about the state of the European economy and its energy markets, what is the likelihood that the “high scenario” cited by the study will occur in 2021 and beyond? How about the “low scenario?” What are the implications for different allowance prices in terms meeting the objectives of the EU-ETS?

Does the MSR vitiate the operation of the EU-ETS as a “market-based” mechanism? If yes, is that problematic?

Given the fact that many believe that volatility in allowance prices can severely undercut investment in technologies to de-carbonize the economy, could there be ways to revise the MSR to avoid the potential price volatility cited in this study?